Boards were just beginning to bask in the milder securities class-action litigation climate. After record numbers of suits in the early part of the decade, the number of cases was dwindling to the point that directors wondered if a permanent change had occurred. There were numerous reasons for such optimism. Courts were holding plaintiffs to higher standards in their allegations of securities fraud. The stock market was fairly steady, and instances of accounting fraud and insider trading were decreasing. To top it all off, Milberg Weiss—enemy number one to many corporate defense lawyers—was being torn apart by its own scandal and fraud case. In other words, things were good.
Then something happened in the second half of 2007 to break the relative calm. The subprime-mortgage crisis unfolded, and concerns about the economy caused stock-market volatility— a chief accelerant to securities class actions—to pick up. More than 100 companies were sued for securities-related allegations in the second part of the year, compared to 116 in all of 2006, reversing a downward trend of eight consecutive quarters of below-average litigation activity.
The reversal of fortune has many board members wondering if this augurs a return to days when an onslaught of securities cases put many companies on the defensive. They are asking: What's causing the shift in litigation? What are the issues being litigated? And what should they be on the lookout for?
Surprisingly, there is some cause for optimism. Experts, including Joseph Grundfest, a professor at Stanford University School of Law and director of its Securities Class Action Clearinghouse, believe that the recent increase is a temporary blip rather than the beginning of a trend. They cite a number of positive developments in litigation that favor corporate defendants over the long-term. In fact, Grundfest says that if you rule out specific events, such as stock-options backdating or subprime-related cases, the downward trend in class-action litigation might continue. Corporate officers are possibly just behaving better, he suggests. "Most corporate managers are not engaging in risky behavior the way they used to be. Accounting is more precise. Books are better kept, the probability of getting caught is much higher than it used to be, and the price you pay is much greater."
Going the Distance
One of those positive developments was the jury verdict in favor of JDS Uniphase Corp. following five years of shareholder litigation. Last November in U.S. District Court in Oakland, Calif., a jury, citing insufficient evidence to show wrongdoing, ruled that four former executives were not guilty of insider trading and securities fraud.
The defendants' victory may embolden other companies to proceed to trial. This is "an important landmark in modern securities litigation," says Grundfest, a former commissioner of the Securities and Exchange Commission (SEC). "These cases rarely go to trial, and for the defendants to win a total victory in a case that claimed $20 billion in damages demonstrates that not every case that makes it past summary judgment has merit. The interesting question is how and whether this trial result might cause plaintiffs to modulate their settlement demands or embolden defendants to take cases to trial."
In its year-end report, the Securities Class Action Clearinghouse cited the JDS Uniphase case as one of the defining events in class-action litigation, along with the guilty plea of former Milberg Weiss Bershad & Schulman partner William Lerach, and the surge in filings related to the subprime-mortgage market crisis. A fourth development that bears note was the Supreme Court decision in Tellabs v. Makor that requires plaintiffs to show stronger evidence of fraud than previously sought.
Experts such as Grundfest believe the reasons for the decline over the last few years stem from better accounting practices, a more stable stock market, and increased federal enforcement activity.
The nature of class actions is also changing. The Stanford report found a "moderate decline"
in the percentage of filings that allege misrepresentations in financial statements and a notable drop in the number of alleged insider-trading cases. The recent surge in new securities litigation is more event-driven, the result of the subprime crisis. Strip out those cases and barring any new event, Grundfest expects the number of class-action filings will continue to remain low.
Stanford's Clearinghouse, in conjunction with Cornerstone Research of Boston, found a total of 166 federal securities class actions were filed in 2007, up 43 percent from 2006. The overall number was still below the historical ten-year average of 194 cases. The financial services sector led the way in securities suits last year with 47 filings; of those, 25 were related to the subprime- market disclosure issues. (The consumer non-cyclical and communications sectors followed with 36 and 33 companies sued, respectively.)
National Economic Research Associates (NERA) reports that the first subprime-related shareholder class action was filed in February against New Century Financial Corp. By December, the total number of subprime-related actions had more than quadrupled. But subprime cases aren't expected to drive an onslaught of litigation into 2008 and beyond. "When litigation related to the subprime crisis is excluded from the calculation—on the assumption that the subprime crisis is a non-recurring event—the resulting core-litigation rate remains well below historical terms," says Grundfest.
Steven Hantler, former general counsel to DaimlerChrysler, and chairman of the American Justice Partnership, a nonprofit group backed by major corporations, agrees that the subprime cases are indicative of the event-driven securities class-action environment. Having watched the development of numerous class-action cases, he says there are common characteristics that readily typify probable class actions. "When I am asked to forecast what's likely to happen," Hantler says, "all I do is look in the newspaper to what kind of injury abounds."
The increase in the number of lawsuits illustrates his point: there are victims—in this case, homeowners—losing their property to banks and mortgage companies. The David versus Goliath angle is ample fodder for reporters and television producers, he contends. The trial bar is comprised "of some of the most sophisticated entrepreneurs in this country." He says that securities suits are following the pattern of product liability cases, where a series of events drives an increase in cases. For a product-liability example, he says the plaintiff bar could pursue toy manufacturers because of lead paint found on toys.
"They're probably retaining medical researchers now to do studies on the long-term effects [of lead exposure] on children, assuming that children have been exposed to lead," he says. Look no further than the litigation over breast implants in the 1990s, he suggests. Study after study found that there was no correlation between silicone-based breast implants and major disease. Even so, before the scientific research could be completed, juries in Houston, San Francisco, Alabama, and elsewhere awarded plaintiffs millions of dollars. Two manufacturers, including Dow Corning, went bankrupt. "The litigants' lawyers created the science and publicized it to the public, where it became almost engrained in our culture. 'Breast implants were bad,' they said. You had victims—innocent women—and you had the big, bad profiteering chemical companies."
The Milberg Weiss Implosion
The recent decline in securities class-action suits could be the result of the criminal charges brought against one of the most notorious class-action litigation firms, according to some observers. Senior partners of Milberg Weiss Bershad & Schulman, including Melvyn I. Weiss, once described by Fortune magazine as "Mr. Class Action," were indicted on conspiracy charges for allegedly orchestrating a scheme by which the law firm paid kickbacks to named plaintiffs in securities class-action cases.
At least seven defendants, including former Milberg Weiss partners Lerach, David Bershad, and Steven Schulman, and former class-action plaintiffs who received kickbacks from the firm, have pled guilty; Weiss maintains his innocence and his criminal trial will be heard in Los Angeles federal court. The result of their indictments on class-action lawsuits in general, according to Hantler, "was a great disinfectant," against what he considers a culture ofunderhanded tactics and the filing of frivolous cases by some law firms.
"The scandal and indictments at Milberg Weiss may have had the greatest effect on reducing class-action litigation, especially securities class action," Hantler says. "It was a mill. They generated hundreds of lawsuits. When the scandal escalated [to criminal indictments], the spigot stopped not just at Milberg Weiss, but also at other firms. It had an effect. It made them all more cautious."
While in 2003 Milberg Weiss was rated number one in the country for the total number of settlement dollars it amassed, by 2006 it had slid to fourth in the rankings. Even so, in RiskMetrics' most recent rankings, Milberg Weiss still had total settlements upward of $1.6 billion. The leading firm in the country, Coughlin Stoia Geller Rudman & Robbins, collected $7.3 billion on behalf of its litigants, per Risk- Metrics.
Grundfest isn't convinced that indictments against Milberg Weiss had such a chilling effect. "The last time I looked," Grundfest argues, "there was no shortage of plaintiff class-action attorneys and there's no shortage of capital to fund class-action litigation. The indictments [of Milberg Weiss partners] having a macro effect doesn't make sense to me. A better explanation may be that if the behavior for which Milberg Weiss partners were indicted was much more pervasive than we'd known, and that behavior has changed as a result of the prosecution, that could have a chilling effect. In which case, isn't that good for business?"
The long-term outlook for securities litigation isn't entirely positive, however. Adam Savett, director of securities class-action services at RiskMetrics, points to another litigation trend that corporate boards and officers should be aware of: international institutional investors becoming increasingly active here in the United States. Legal observers say this trend is being driven in part by a growing number of affiliations between U.S. and overseas law firms. In some instances, these firms have reached out to provide "educational" campaigns to international institutional investors. For example, Schiffrin Barroway Topaz & Kessler in November announced a strategic alliance with Man-Barak Advocates & Solicitors, an Israeli-based law firm. Schiffrin Barroway has similar affiliations with law firms located in Germany and Italy.
RiskMetrics' SCAS studied the issue and found that since 2000 there has been a steady rise in the percentage of U.S. securities class actions with international institutional investors as the lead plaintiffs. While some 17 countries have filed at least one claim, the most activity originates from investors in Canada, Australia, The Netherlands, and Israel. A fifth country that bears watching, according to Savett, is South Korea, which now allows securities class-action suits to be filed in its country but so far has seen no activity.
Settlement Values Rise
Some researchers aren't convinced that the recent increase in securities suits is a hiccup, based on non-recurring events. NERA's year-end research reports that even after excluding subprime and options backdating cases, the number of standard securities suits increased nearly 40 percent from 2006, according to study co-author Stephanie Plancich, a senior consultant at NERA. She says it is too early to determine if 2007 was an aberration or a change in the underlying trend. "Filings are back up to 2005 levels," Plancich says. Average settlements have also increased in size: NERA reports the average settlement paid to resolve a shareholder class action peaked last year at $33.2 million. The median settlement also increased to the new high of $10 million.
If securities litigation continues to be driven by event-based cases, there are issues now on the horizon that could portend new class actions. Global climate change and injury caused by tainted products could pose threats.
Meanwhile, lawmakers have called on the Securities and Exchange Commission to hold a roundtable to review the impact of securities class-action lawsuits on U.S. competitiveness. A letter written to SEC Chairman Christopher Cox from Congressmen Vito Fossella (R-N.Y.) and Gregory Meeks (D-N.Y.) asked Cox to hold such a roundtable, but no date has been set. While both lawmakers have been quoted in news reports saying they support the right of defrauded shareholders to join in legal actions, they expressed concern about the possibility of an increase in size and frequency of securities class-action lawsuits. Fossella also requested that the SEC conduct a review of securities litigation to see if it is deterring fraud and providing relief to harmed investors—in effect, is it doing its job? The last time Congress addressed securities suits in a big way was with the Private Securities Litigation Reform Act of 1995. While the 1995 Act included sweeping changes, many critics have labeled it ineffective at stopping frivolous securities suits.
In the face of litigation threats, what are corporate directors and officers to do? Stanford's Grundfest offers this advice: "Take a good and careful look at your indemnification and the corporation's insurance policy. Directors who do everything they can to prevent litigation need to know that in the event of a suit, they can mount a proper defense." Secondly, he says, officers and directors need to undertake what is "rational and reasonable to minimize the risk of litigation—that means using plenty of common sense and having a healthy respect for process."